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Economics · Lesson 1
Supply and Demand
Nobody sets the price of an avocado. Millions of buyers and sellers do, without ever meeting.
A drought hits farms in one country, and a week later guacamole costs more at your local taco place. A new phone launches, and last year's model gets cheaper. Behind both stories is one simple model, and once you can draw it, you'll start seeing it everywhere.
In this lesson you'll learn the laws of demand and supply, how to read the two curves, the difference between a shift and a slide, how markets find an equilibrium, what happens under price ceilings and price floors, and a first look at elasticity.
Markets and the law of demand
A market is any place, real or online, where buyers and sellers trade a good or service. It can be a farmers' market, a ticket app, or the whole world's trade in avocados.
Throughout this lesson we'll follow one made-up market: avocados in a big city, with prices in dollars and quantities in thousands of avocados a week. The numbers are invented to keep the math clean, but the patterns are real.
Demand is how much of something buyers are willing and able to buy at each possible price. The amount they want at one particular price is the quantity demanded.
The law of demand: other things equal, when the price of a good rises, the quantity demanded falls. When the price falls, the quantity demanded rises.
Why? When avocados get pricier, some people switch to something else (a substitute, like salsa), and everyone's money stretches less far. "Other things equal" (economists sometimes say ceteris paribus, Latin for "other things being the same") means we change only the price and hold everything else fixed: incomes, tastes, other prices.
| Price | Quantity demanded (thousands per week) |
|---|---|
| $1.00 | 80 |
| $1.50 | 70 |
| $2.00 | 60 |
| $2.50 | 50 |
| $3.00 | 40 |
Economists put price on the vertical axis and quantity on the horizontal one. It's backwards from most math graphs, a habit that goes back to Alfred Marshall in the 1890s, so don't let it trip you up.
The law of supply
Supply is how much sellers are willing and able to offer at each possible price. The amount at one particular price is the quantity supplied.
The law of supply: other things equal, when the price of a good rises, the quantity supplied rises. When the price falls, the quantity supplied falls.
A higher price makes it worth the extra effort and cost: growers pick more of the crop, ship from farther away, and plant more trees for next year. At a low price, some sellers decide it isn't worth it.
| Price | Quantity supplied (thousands per week) |
|---|---|
| $1.00 | 20 |
| $1.50 | 40 |
| $2.00 | 60 |
| $2.50 | 80 |
| $3.00 | 100 |
Equilibrium: where the curves cross
Put both curves on one graph and they cross at one point. That point is the equilibrium: the price at which the quantity buyers want equals the quantity sellers offer. Nothing is left over and nobody who's willing to pay that price goes without.
You can find it from the tables: at $2.00 both columns say 60. You can also find it with algebra by setting the two equations equal:
Demand: Qd = 100 − 20P
Supply: Qs = 40P − 20
100 − 20P = 40P − 20
120 = 60P → P = $2.00
Q = 100 − 20(2) = 60 thousand
How does a market get there?
No one has to calculate anything. If avocados sit at $3.00, sellers bring 100 thousand but buyers want only 40 thousand. That leftover pile is a surplus. Stores mark prices down to clear the shelves, and the price drifts toward $2.00.
If avocados sit at $1.00, buyers want 80 thousand but sellers bring only 20 thousand. That gap is a shortage. Shelves empty, sellers notice they could charge more, and the price rises toward $2.00.
“We might as reasonably dispute whether it is the upper or the under blade of a pair of scissors that cuts a piece of paper, as whether value is governed by utility or cost of production.”
Marshall's point: arguing about whether buyers or sellers "set" the price misses the picture. You need both blades, demand and supply, to cut a price.
Shift or slide? The most-missed idea
This is where most students (and plenty of headlines) get tangled. There are two very different ways the amount bought can change.
The rule of thumb: a change in the good's own price moves you along a curve. A change in anything else shifts the curve. A shift to the right means more at every price (an increase). A shift to the left means less at every price (a decrease).
What shifts demand
- Income. For a normal good (restaurant meals), more income raises demand. For an inferior good (store-brand instant noodles, for many people), more income lowers it.
- Prices of related goods. If a substitute gets cheaper, demand falls. If a complement (something used together, like chips with guacamole) gets cheaper, demand rises.
- Tastes and information, like a health study or a viral recipe.
- Expectations about future prices or income.
- Number of buyers, like a growing city.
What shifts supply
- Input costs: wages, fuel, fertilizer, water.
- Technology that makes production cheaper.
- Number of sellers.
- Nature and weather: droughts, freezes, good harvests.
- Taxes and subsidies on producers.
- Expectations about future prices.
| Change | Price | Quantity |
|---|---|---|
| Demand increases (shifts right) | Rises | Rises |
| Demand decreases (shifts left) | Falls | Falls |
| Supply increases (shifts right) | Falls | Rises |
| Supply decreases (shifts left) | Rises | Falls |
If both curves shift at once, you can predict one of the two outcomes, but the other depends on which shift is bigger. Try it in the market lab below.
The market lab
Move the curves yourself. Shift demand and supply, change how sensitive buyers are to price, and try a price ceiling or floor. The readout does the algebra for you, using the same avocado equations as above.
Try a story:
Things to try: Make buyers "barely" price-sensitive, then cause a drought. Why does the price jump so much more? Set a ceiling at $1.50, then add a health craze: what happens to the shortage?
Shortages, surpluses and price controls
Sometimes governments decide a market price is too high or too low and set a legal limit. These rules are called price controls, and there are two kinds.
- A price ceiling is a legal maximum price. It only matters (economists say it binds) if it's set below the equilibrium price. Example: rent control.
- A price floor is a legal minimum price. It binds only if it's set above the equilibrium price. Example: a minimum wage, which is a floor on the price of labor.
With a binding ceiling, the price can't rise to clear the shortage, so goods get handed out some other way: waiting lists, lines, "first come, first served," or connections. With a binding floor, the leftover can't be cleared by cutting the price, so some sellers simply can't find buyers.
That's the basic model. Real policy debates are about how big those effects are, who gains, who loses, and whether other goals are worth the tradeoff. Here are two well-studied cases. Notice that the evidence includes benefits as well as costs.
Case 1: Rent control in San Francisco
In 1994, San Francisco extended rent control to many small apartment buildings built before 1980. Economists Rebecca Diamond, Tim McQuade and Franklin Qian compared buildings that were newly covered with similar buildings that weren't. Their study, published in the American Economic Review in 2019, found effects on both sides:
Gains they found
- Rent control reduced tenant mobility: covered tenants were more likely to stay at their address than similar tenants who weren't covered. In the authors' words, it “limits renters' mobility by 20 percent.”
- It lowered displacement: fewer covered tenants were pushed out of San Francisco.
Costs they found
- Landlords of covered buildings cut the rental housing they offered by about 15%, often by converting units to condos or redeveloping.
- Less rental supply likely raised market rents across the city (the working-paper version estimates about 5%), working against the law's goal for future renters.
Case 2: The minimum wage
The U.S. federal minimum wage has been $7.25 an hour since July 24, 2009, and many states and cities set higher minimums. In 2019 the nonpartisan Congressional Budget Office (CBO) estimated what raising it to $15 by 2025 would do:
Gains CBO estimated
- Higher pay for about 17 million workers, and possibly another 10 million earning a bit more than $15.
- About 1.3 million fewer people living in poverty.
Costs CBO estimated
- About 1.3 million workers who would otherwise have jobs being jobless in an average week in 2025 (its middle estimate).
- A wide range of uncertainty: CBO gave a two-thirds chance that the job change would be anywhere from about zero to 3.7 million fewer jobs.
Why such a wide range? The simple model assumes a competitive labor market with many employers. In a December 2019 supplement, CBO explains that where employers have power over wages (economists call this monopsony), a modest minimum wage can raise both pay and employment, but only in a limited range of circumstances; set high enough, it reduces jobs again. CBO found evidence of this power in some low-wage markets, and economists still debate how widespread it is.
How do we know? Economists can't run a lab experiment on a whole city. Instead they look for "natural experiments": a law that covers some buildings or workers and not others that are otherwise similar, and then compare what happens to each group over time. That's exactly what the San Francisco study did with the 1980 construction cutoff.
A first look at elasticity
The law of demand tells you the direction: higher price, less bought. Price elasticity of demand tells you how much. It compares the percentage change in quantity demanded with the percentage change in price.
Elasticity = (% change in quantity) ÷ (% change in price)
Midpoint method: % change = change ÷ average of start and end
Worked example
Avocados go from $2.00 to $2.50, and the quantity demanded falls from 60 to 50 thousand.
% change in quantity = (50 − 60) ÷ 55 = −18.2%
% change in price = (2.50 − 2.00) ÷ 2.25 = +22.2%
Elasticity = −18.2 ÷ 22.2 ≈ −0.82
The minus sign just says price and quantity move in opposite directions, so economists usually look at the size (the absolute value). Here 0.82 is less than 1, so demand is inelastic in this range: quantity changed by a smaller percentage than price.
- Elastic (more than 1)
- Buyers react strongly. Example: one brand of bottled water when the cooler is full of others.
- Unit elastic (exactly 1)
- Quantity changes by the same percentage as price.
- Inelastic (less than 1)
- Buyers barely react. Examples: insulin for a person who needs it, or gasoline over the next week.
What makes demand more elastic?
- Close substitutes. If there's an easy swap, buyers switch.
- Luxury versus necessity. People cut back on extras before essentials.
- Share of your budget. A 20% jump in the price of salt barely matters; a 20% jump in rent does.
- Time. Over a week you're stuck with your car; over years you might buy a more efficient one or move closer to work.
Elasticity explains why a small drought can cause a big price spike in something people feel they must have: when demand is inelastic, the price has to rise a lot before enough buyers back off. You can watch that happen in the market lab with "Barely (inelastic)".
In the real world
- Concert tickets
Why tickets resell for more
A venue has a fixed number of seats (supply can't grow). If the face price is set below what fans will pay, there's a shortage at that price, so tickets go fast and resale prices climb toward the market level.
- Ride apps
Surge pricing
When everyone wants a ride at once, a higher price does two things: some riders wait or walk (movement along demand), and more drivers head out (movement along supply). Critics say it feels unfair in emergencies; supporters say it gets more cars on the road.
- Last year's phone
The new model effect
When a new model launches, many buyers see the old one as a weaker substitute. Demand for it shifts left, and its price usually falls.
- Seasonal produce
Summer strawberries
In peak season, a big harvest shifts supply right, so prices drop and people buy more. Out of season, supply has to come from farther away, and prices rise.
Practice: shift or slide?
Read each news flash. Decide which curve moves and which way, or whether it's just a movement along a curve. Think about the market named at the top, not other markets.
Quiz: check your understanding
Nine questions. Pick one answer for each, then check. Your best score stays in this browser only.
Talk about it
These have no single right answer. Use the model, and say what you'd want to know more about.
- Is it fair for a store to raise the price of bottled water during a hurricane? What would happen to the supply of water if it couldn't? What would happen to people who can't afford it if it could?
- The San Francisco study found that rent control helped the tenants who had it but likely raised rents for future renters. How would you weigh help for people now against costs for people later?
- A city is debating a higher local minimum wage. What facts about its local job market would you want before deciding?
- Think of something you buy where you'd barely change how much you buy even if the price doubled. What makes your demand so inelastic?
- Pick a recent news story about a price going up. Was it a shift in demand, a shift in supply, or both?
Key terms
- Demand
- How much buyers are willing and able to buy at each price.
- Quantity demanded
- The amount buyers want at one particular price.
- Supply
- How much sellers are willing and able to offer at each price.
- Equilibrium
- The price and quantity where quantity demanded equals quantity supplied.
- Shortage
- Quantity demanded is greater than quantity supplied (price is below equilibrium).
- Surplus
- Quantity supplied is greater than quantity demanded (price is above equilibrium).
- Price ceiling
- A legal maximum price; it binds when set below equilibrium.
- Price floor
- A legal minimum price; it binds when set above equilibrium.
- Price elasticity of demand
- % change in quantity demanded ÷ % change in price.
- Substitute / complement
- Goods used instead of each other / goods used together.
- Normal / inferior good
- Demand rises with income / demand falls as income rises.
Sources
- OpenStax, Principles of Economics 3e: 3.1 Demand, Supply, and Equilibrium, 3.2 Shifts in Demand and Supply, 3.4 Price Ceilings and Price Floors and 5.1 Price Elasticity: definitions, shifters, ceteris paribus, midpoint method.
- Alfred Marshall, Principles of Economics, 8th ed. (1920), Book V, Chapter III, “Equilibrium of Normal Demand and Supply,” §7 (Library of Economics and Liberty; public domain): the scissors quotation, checked word for word against this full text.
- Diamond, McQuade and Qian, “The Effects of Rent Control Expansion on Tenants, Landlords, and Inequality: Evidence from San Francisco”, American Economic Review 109(9), 2019; working paper with the 5.1% rent estimate: NBER Working Paper 24181.
- Congressional Budget Office, The Effects on Employment and Family Income of Increasing the Federal Minimum Wage (July 2019; full report PDF): the job, pay and poverty estimates; and its supplement, The Minimum Wage in Competitive Markets and Markets With Monopsony Power (PDF, December 2019): the monopsony paragraph.
- U.S. Department of Labor, History of Federal Minimum Wage Rates, 1938–2009: $7.25 effective July 24, 2009.
Credits: all graphs and drawings are original art made in code for Jugami (SVG on the page; the share image is the same art rendered to JPG). The avocado market numbers are made up for teaching; real-world figures come from the sources above. This page teaches economic ideas; it isn't financial, legal or policy advice.